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Starting a Company:

Top Ten Legal Issues for Startups Harvard Business School November 13, 2003 John H. Chory Michael D. Bain. Starting a Company:. Entity Formation Founder Arrangements Intellectual Property Employment Raising Capital. What Type of Entity Should You Create?. 1. Entity Formation.

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Starting a Company:

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  1. Top Ten Legal Issuesfor StartupsHarvard Business SchoolNovember 13, 2003John H. ChoryMichael D. Bain

  2. Starting a Company: Entity Formation Founder Arrangements Intellectual Property Employment Raising Capital

  3. What Type of Entity Should You Create? 1. Entity Formation Subchapter S Corporation Subchapter C Corporation Partnership Limited Liability Company

  4. 1. Entity Formation • “Pass through” tax treatment • All owners have limited liability • Limited to 75 owners • Non-resident aliens and corporate stockholders are not allowed • Only one class of stock is permitted (voting differences acceptable) S Corporation:

  5. 1. Entity Formation C Corporation: Double taxation All owners have limited liability No restrictions on types of owners No maximum number of owners Permitted to have different classes of stock

  6. 1. Entity Formation • “Pass through” tax treatment • Not all owners have limited liability • No limit on number or type of owners Partnership:

  7. 1. Entity Formation • Pass-through tax treatment • All owners have limited liability • No limitation on number or types of members • VC’s usually won’t invest in LLCs • No “tax-free” reorganizations • Employee compensation issues • Cost and time to administer Limited Liability Company:

  8. 1. Entity Formation • Obtain VC funding • Go public • Do a “tax free” M&A deal • Use equity to compensate employees Become a C-Corp If You Want To:

  9. 1. Entity Formation Where Should Your Company Be Incorporated? D E L A W A R E

  10. Ownership: • Founders should agree on ownership allotments early, including consideration for property, cash, time and effort • Restricted Stock Agreements: • Vesting Terms: • vesting up front • remaining vesting schedule • acceleration upon termination of employment • change of control acceleration * Investors may change deal later * 2. Founder Arrangements

  11. Other Terms: • restrictions on transfer of shares • lock-up • Make sure founders assign all intellectual property rights to the company • No founder licenses to the company 2. Founder Arrangements

  12. Possible Answers: • You • People who collaborated with you • Former employers 3. Who Owns IP Created Prior To Incorporation?

  13. Assignment of Inventions Agreements: • Require disclosure of all innovations • Assign ownership of innovations to Company • Don’t forget consultants 4. Protecting the Company’s IP

  14. 4. Protecting the Company’s IP • Institute a Trade Secret Protection Program: • Information must have limited availability • Its limited availability must give it economic value • Must take “reasonable precautions” to keep it secret • only disclose trade secret or other confidential business information under nondisclosure agreements • implement and follow procedures

  15. 4. Protecting the Company’s IP • Patents: • Broadest form of protection, but most expensive to obtain and enforce • Why do you want patents? • offensive purposes - marketing purposes • defensive purposes - satisfy investors • Understand the provisional application process and foreign patent process • Educate your employees on the process and its importance: • disclosure programs - incentives

  16. 4. Protecting the Company’s IP Trademarks: • Is company name going to be critical for marketing purposes? • conduct thorough searches • select a protectable name • don’t fall in love with your company name before it is cleared as a trademark • allow time for the process

  17. Use a well-crafted offer letter: • Avoid employment contracts • Employment is at will • No violation/conflicts with former employer agreements • be aware of existing restrictive covenants 5. Building a Team

  18. 5. Building a Team • Invention and Non-Disclosure Agreements • Non-Competition and Non-Solicitation agreements • enforceable if reasonable in scope and duration • Evaluate Immigration Issues

  19. Compensation: • Employees must get paid • Be careful compensating with stock • tax issues for employee or consultant / withholding obligations • Equity: • Restricted Stock: • best tax benefits for employees • limit restricted stock grants to founders and early employees • ISO’s – for employees • NSO’s – for directors and non-employees 6. Compensation/Equity Issues

  20. Considerations: • avoid family and friends if possible • seek “accredited investors”: • a director or executive officer of the company • a person with a net worth, together with spouse, of more than $1.0 million • a person who has had income greater than $200,000 for the past two years or joint income with spouse greater than $300,000 for the past two years • minimize number of stockholders and transaction costs • vc-friendly terms and conditions • speed 7. Raising Seed Capital

  21. 7. Raising Seed Capital • Typical Fund Raising Vehicles: • Sell Common Stock: • easy • valuation problems • dilution • not attractive to investors

  22. 7. Raising Seed Capital • Sell Preferred Stock: • valuation issues • expensive • give up lots of control for little money • Sell Convertible Debt: • straightforward transaction with low transaction costs • can convert into next round • does not provide a current valuation • can be accompanied by an equity component

  23. What are VC’s looking for in an investment? • Strong management team • previous home runs • Sound business proposition • unique idea • technology/IP advantage • big market • sound strategy to break into, and lead in, the market 8. Raising Money from VC’s

  24. 8. Raising Money from VC’s • Business Plans: • Prepare a comprehensive business plan; use realistic financial models • Approach a selected number of venture capitalists • Find the right venture capitalist: • Do they have experience with similar types of investments? • Do they take an active or passive management role? • Are there competing companies in their portfolio? • Are the personalities compatible? • Can they help provide contacts for industry relationships?

  25. Liquidation Preferences: • participating preferred • super liquidation preferences(2x, 3x or more) • Dividends: • accruing • cumulative • when are they paid? 9. Venture Capital Terms

  26. Anti-dilution Adjustments: • weighted average • full ratchet • pay-to-play • carve outs • Redemption Rights: • mandatory • optional • when is it triggered? • what price? • Covenants and other protective provisions • Preemptive rights 9. Venture Capital Terms

  27. Carefully select entity • Observe corporate formalities: • have good records • hold regular board meetings; keep minutes • properly authorize stock issuances and major contracts • Things that could trip you up: • severance payments • accelerated vesting • tax issues • consents 10. Preparing for a Liquidity Event

  28. Always Aim To: • Keep things simple • Minimize transaction costs • Maintain flexibility • *** Do the right thing now – it will save you time, effort and expense later *** Conclusions

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